What is Process Costing: A Beginner’s Guide
A lot of business owners get confused by the process costing method. Process costing is a bookkeeping method that involves assigning costs to similar products. The method is used when products are produced in a large batch.
In this blog post, we will explain the costing method using examples. After reading the post, you will know about the method that your outsourced bookkeeping service provider used to assign costs to products.
Process Costing Simplified
Process costing is used when a manufacturing company mass produces similar items. The method is appropriate when the cost of individual items cannot be identified. The basic assumption when using this method is that the cost of individual units cannot be identified. The total cost of producing a batch of products is divided equally between the products.
As the name suggests, process costing is used in industries where a finished product passes through two or more processes.
Process cost aims to find out the cost of each process. The process cost consists of four major expenses.
- Material cost
- Transport cost
- Labor cost
- Direct expenses and indirect cost
Let’s look at each of the above costs involved in process costing.
Material cost
The cost of material includes all those costs involved in processing it. The material costs include invoice price, cartage, transportation, insurance, storage costs, and sales taxes. Most of these costs are included in the invoice received from the supplier.
Any discount receivable from the supplier is deducted from the cost of the material. Discounts offered by suppliers are of three types. These include trade discounts, quantity discounts, and cash discounts. Trade discounts are generally given by wholesalers to retailers. The quantity discount is given for buying large quantities of materials. Suppliers offer a cash discount to buyers who pay the invoice amount before the payment due date.
Transport Cost
Transport and storage cost of material is the cost incurred in transporting goods to the premises. This cost is generally not included in the invoice.
Labor Cost
Labor cost is the cost of labor required to process the material. This cost is also not included in the invoice issued by the seller. Both transport and labor cost
Direct and Indirect Cost
Material costs such as can be added as the direct or indirect cost of materials. The direct cost can be directly attributed to a material. In contrast, the indirect cost cannot be identified. For instance, the cost of transporting different materials cannot be attributed. Therefore it is added as an indirect overhead cost and attributed equally among the materials.
Methods of Process Costing
Professional bookkeepers use different methods for process costing. The common types of process costing include the following.
Cost Price Method
Cross price method involves assigning the actual cost to materials. The price is assigned to materials using First in First out (FIFO), Last in First Out (LIFO), and Highest in First Out (HIFO) methods.
Suppose that ABC LLC purchases 100 products A on June 2nd for $500. The company then purchased 50 products B for $600. Under the FIFO method, the cost of goods sold will be $500 for the first 100 products sold and $600 for the next 50 products. In contrast, the cost of goods sold under the LIFO method will be $600 for the first 50 products sold and $500 for the next 100.
The cost of goods sold under the HIFO method will be $600 for the first 50 products and then $500 for the remaining 100 products. Under this method, the cost of goods sold will be the highest price irrespective of whether the material at that price was purchased first or last.
Weighted Price Method
The weighted cost method involves assigning the cost based on the weighted average cost of the product. In the previous example regarding process costing, the average cost is $550. The cost of each product sold will be $550.
Weighted costing methods are of different types. These include the simple average method, weighted average method, periodic simple average method, moving simple average method, and moving weighted average method. You must contact your bookkeeping accountant to know about the suitable type of process costing method for your company.
Notional Price Method
The notional price method involves assigning a predetermined price to the products. The actual price of the material is not accounted for under this method.
Notional price methods are of different types. These include the standard price method, inflated price method, re-use price method, and replacement price method.
The Standard pricing method involves fixing a standard price for each material. The difference between the actual and standard price is calculated as a profit or loss on closing stock value. Using the method simplifies the process of assigning costs to materials. It allows a uniform price for all materials. The method also avoids bookkeeping errors in recording the price of materials.
The inflated pricing method involves accounting for contingencies in pricing the products. The price of material includes the actual price plus the cost of handling and storage, damage to the product, storage and handling cost, and others. This method assigns the full cost incurred in processing the material.
The Re-use pricing method is for the costing of reused material. The price includes the actual cost plus the cost of re-issuing the product that has been returned by the buyers for whatever reason.
The Replacement costing method involves costing the material at the current prices plus production costs. The method results in a profit when the price rises and decreases when the price decreases.
Conclusion
Process costing helps in keeping tabs on the cost of goods sold. It allows a manufacturing firm in calculating the gross profit on sales of goods. The bookkeeping method is particularly used in industries such as oil, textile, chemical, construction, and food manufacturing sectors.
Make sure that you hire professional accountants for process costing. Using the correct process costing requires a deep understanding of accounting rules.
Maxim Liberty Inc has a team of experienced CPAs that provides professional bookkeeping services in the US. We have decades of experience in providing bookkeeping services to various types of organizations. You can contact us by dialing (703) 957-6938.
